The View Two Months Out

Summer is over. The historically difficult period for the market is not, however. Yet, in two months, perceptions of the fundamentals could be substantially improved. That could set the stage for a solid year-end rally.

Overview

Two months from now, there is a very real possibility that:

1) It finally becomes recognized that the U.S. economy is growing at a decent pace.

2) The inflation outlook is significantly improved.

3) The earnings outlook is viewed much more favorably.

Instead of driving by looking in the rear view mirror at the horror of the housing debacle, the market may finally start to look forward to a more optimistic 2009.

Seasonality

Before reviewing the three major fundamentals listed above, it must be noted that September and October have historically been difficult months for the stock market. This is in part because some of the more noteworthy crashes have occurred in these months.

It is hard to explain, but it is indeed true that the six months of May-October have, over the past 50 years, provided none of the overall return in the stock market.

The entire gain in the Dow Jones Industrial Average the past 50 years has occurred in the months of November-April.

One could do a lot worse than playing the stock market by simply taking defensive positions every May, and getting aggressive every November.

This year, the fundamentals will also fall into place by November, adding to the prospect for a year-end rally.

The Economy

The announcement last week that second quarter real GDP rose at a 3.3% annual rate did little to quiet the economic bears.

The press eagerly quoted economists who claimed that the second quarter growth rate was aberrant and due primarily to foreign demand (as if that did not count). The very same economists who have bombastically forecast a recession and declines in real GDP for both the first and second quarter are now saying that the weakness will finally be evident in the third and fourth quarter numbers.

The only problem is that they will be (very) wrong yet again.

The trends in the components suggest that third quarter real GDP will post a gain of 2.5% and perhaps much higher.

Net exports will be very strong again in the third quarter, consumer spending will be up yet again, and business investment is likely to post another modest gain. The only category of GDP that is likely to be down is residential housing, and there the declines are moderating. Inventories will add to GDP in the third quarter.

There just isn't any evidence of a consumer-led recession or a contraction in business investment. Period.

A second straight quarter of real GDP growth near 3% should finally convince the bears that disaster is not just around the corner.

The initial (advance) government report on third quarter real GDP will be the last week of October. If the first and second quarters are a guide, forecasts as soon as two weeks ahead of the report will be very low, only to rise to realistic levels a week ahead of the report.

Economic perceptions of current conditions and the outlook for 2009 could improve significantly with the next couple of months.

Inflation

The next two CPI numbers are likely to be negative.

The decline in gas prices that has already occurred will produce negative CPI changes for August and September (assuming that prices do not suddenly spike). This will obviously help inflation perceptions.

The core rate of CPI inflation has picked up to 0.3% the past two months. In our opinion, this is due more to cost pressures than to strong demand. If so, then the core rate may also ease back to a 0.2% trend.

By the time the September CPI is reported in mid-October, inflation concerns could have eased substantially. Optimism will be tempered by the ever-present possibility of rising commodity prices, but a cooling of demand due to slower global economic growth should keep fears in check.

Earnings

The biggest surprise could come from improved earnings expectations over the next two months.

It is not well recognized that the current earnings weakness is due almost entirely to the write-offs at financial firms.

Excluding financials, earnings were UP 5.7% in the second quarter. Including financials, earnings fell 20.6%.

Forecasts for the third quarter are for earnings excluding the financial sector to be up 11% in the third quarter, and 14% in the fourth quarter.

Those forecasts may be optimistic, but they show that the earnings problem lies in the financial sector and that there is indeed underlying earnings growth.

In fact, there is a good chance that a couple of months from now, as third quarter earnings reports from financial companies are being wrapped up, that the outlook into 2009 improves dramatically.

It is true that the market over-anticipated an end to the write-offs in the second quarter, and may be a bit overly optimistic for the third quarter, but the ABX index on which many MBS assets are valued, is currently flat with the end of the second quarter. The end of the write-offs will come.

Looking into 2009 then, the outlook for earnings could appear much, much better.

If financial earnings pick up from the write-off depressed levels of the first half of 2008, strong earnings gains could be reported. Current Wall Street forecasts call for 28% earnings growth in the first quarter of 2009 and 24% growth for all of next year.

The focus typically shifts to next year's earnings outlook in the fall. A similar shift this year over the next two months will focus attention on the prospect for overall earnings growth. This will be particularly true if financial company reports in mid-October suggest that write-offs will be limited in the fourth quarter and into 2009.

Value

The shift in earnings expectations will lead to some very impressive value considerations.

Current forecasts are for the S&P 500 in aggregate to earn about $106 next year. At the current price of 1283, that puts the S&P 500 at a forward looking P/E of just 12.

As soon as it becomes accepted that the worst of the write-offs are over (which may happen with the third quarter financial earnings reports in mid-October), the overall market will reflect very good value.

What it All Means

The recent market obsession with the housing crisis and its related manifestations is totally understandable. However, sound investing requires anticipating the changes in market perceptions that could occur.

Over the next two months, the perceptions on the fundamentals could change dramatically.

The economic data will continue to be good if not great, the inflation data will unquestionably improve substantially, and the earnings focus could shift to a much improved outlook for 2009.

September and October are traditionally difficult months for the stock market and could be again. We are not saying a rally will occur soon. Nor are we saying that the housing market will recover any time soon. The housing slump will continue into 2009 and remain a drag on overall economic growth.

But the fundamentals are improving relative to current perceptions. There will be greater recognition of this over the next two months.

It is time to start thinking about positioning for a year-end rally and an improved outlook for 2009.

--Dick Green, Briefing.com